Monopsony, Rigidity, and the Wage Puzzle (Wonkish)

Once a year my academic base, CUNY’s Stone Center on Socio-Economic Inequality, holds a workshop featuring cutting-edge research on inequality. At this point in my life, I can’t claim to be doing cutting-edge research (hey, even Paul Samuelson was writing mostly survey papers and history of thought by the time he was in his 60s); but I’m still asked to give a talk on research issues that I find interesting, hopefully with some relationship to the general theme of the workshop. One virtue of this grand-old-man role, by the way, is that it forces me to tear myself away for a little while from the awful political headlines.

In the past I’ve used the ECINEQ talk to discuss issues involving inequality and macroeconomic performance, both vulnerability to crises and long-term growth. Both areas are still very much unresolved; but I’m not sure I have anything new to say. So I thought I’d do something different, and focus on an issue some very smart economists have been worrying at: the puzzle of continuing wage stagnation despite very low unemployment.

An aside: the way this discussion is taking place marks a kind of new frontier in the mechanics of scientific communication – and, I think, an unfortunate one. Once upon a time economic debate took place in the pages of refereed journals, but that stopped being true at least 30 years ago, with working papers becoming the principal means of communication. Even that turned out to be too slow in the face of rapid change; so during the crisis years, say from 2008-2013, a lot of discussion and debate moved to blogs, which I’d say worked very well. In retrospect, the debates we all had over leverage, monetary policy, fiscal policy and more were really classic – the 21st-century equivalent of, say, Keynes vs. Ohlin on trade balances and relative prices.

But this latest debate has taken place largely through dueling Twitter threads – which is, I’d say, awful. The economists involved are very smart, and the threads very informative; but for people trying to keep track, including students, this is really a mess. If you want an entry point, you might try this tweet by Nick Bunker. But guys, we really need something like, you know, articles – blog posts would do the trick — that summarize your positions.

I guess I’m doing some of that here, but we need clear statements by the principals.

OK, complaints registered. What I want to do now is, first, describe the wage puzzle; then describe the resulting debate, which is largely over how much if any slack remains in the labor market; then lay out a story which combines the issue of downward nominal wage rigidity – which has been discussed fairly extensively – with the role of monopsony power in labor markets, which I don’t think has been integrated into this debate, but should be.

1. The wage puzzle

From the mid-1990s until the 2008 financial crisis, it looked as if there was a fairly stable Phillips curve – a relationship between unemployment and the rate of wage growth. This wasn’t the “accelerationist” Phillips curve that underlies the concept of the natural rate of unemployment – there was no sign that low unemployment led to accelerating inflation. It was, instead, a neo-paleo-Keynesian relationship between unemployment and wages. You can see how good the relationship looked in Figure 1, in which wage growth is measured on the left axis and the inverse of the unemployment rate on the right axis:

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Figure 1

After the crisis, wage growth dropped – but only about as much as it dropped in the early 2000s slump, despite much higher unemployment. And it has increased only modestly since then, to levels well below pre-crisis growth, despite unemployment rates as low as we’ve seen in a very long time:

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Figure 2

It’s a puzzle. But why does the explanation matter? Basically, we’re trying to assess the current state of the U.S. economy, which has lots of implications for monetary and fiscal policy. The unemployment rate, plus some other indicators I’ll get to shortly, suggest an economy pretty much at full employment. But sluggish wage growth could indicate that there’s still substantial slack in the labor market. Which is it?

2. A slack-jawed debate

On the case for substantial slack: a number of economists have argued that the official unemployment rate, which only counts people actively looking for work, has become an increasingly inaccurate guide to the real state of labor markets. Their main point is that if we focus on employment rather than unemployment – specifically, the fraction of prime-working-age adults currently working (EPOP) – it’s still significantly below pre-crisis levels. And using recent data, EPOP is a better predictor of wage growth than the unemployment rate. Ernie Tedeschi has a very good thread (but, alas, not a blog post) making this case.

Jason Furman, however, pushes back in another thread. (Guys, this is really a terrible way to do this kind of discussion.) You can see both Tedeschi’s point and Furman’s counter, done roughly, in Figure 3.

EPOP is indeed still significantly below its pre-crisis level. But it has been a decade since the crisis – and that’s enough time to worry about secular trends in labor force participation. In particular, there’s been a long-run trend toward fewer prime-age men working, and it’s not at all clear that we’re currently below that trend.

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Figure 3

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CreditYuriko Nakao/Reuters

Two other pieces of data also cast doubt on the unmeasured-slack hypothesis. One, shown in Figure 4, is the quits rate – the fraction of workers quitting their jobs each month:

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Figure 4

Quits rates vary with the state of the labor market: workers are more willing to quit if they feel sure of finding another job. And quits are back up to pre-crisis levels, suggesting that the labor market really is tight.

Another piece of evidence is what employers say about the ease of finding workers. And both news accounts and surveys like the NFIB (Figure 5) show employers screaming about either worker shortages or skill shortages, with the latter meaning “we can’t find workers we want at current wages.”

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Figure 5

All in all, I think I come down on Jason Furman’s side here – not with 100% certainty, to be sure, but this really shows most of the signatures of a full-employment economy.

But in that case, why aren’t wages surging?

3. The interaction between monopsony and sticky wages

One old concept that has been overwhelmingly supported by the experience of the Great Recession and aftermath is the idea of downward nominal wage rigidity. Employers are extremely unwilling to cut wages, largely because they fear the effects on worker morale. Meanwhile, in a depressed, low-inflation economy, a lot of employers would want to cut wages if they could do it without side consequences. So as the San Francisco Fed’s wage rigidity meter (Figure 6) shows, the slump caused a surge in the number of workers whose wages didn’t change at all from year to year.

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Figure 6

There have already been some analyses suggesting that an extended period of wages constrained by downward rigidity has created a sort of backlog of pent-up wage cuts that is currently holding down wage increases. But I think we need to say more about the context.

My starting point is that there’s now a lot of evidence that many employers have considerable monopsony power in the labor market: that is, they don’t face a going market wage they have to meet or be unable to hire at all, they face what amounts to an upward-sloping supply curve.

Figure 7 illustrates the position of such a firm. Marginal revenue product is the value to the firm of an additional worker. The supply of labor to that firm is upward sloping: From its point of view, to attract more workers the firm needs to raise wages. But if it does that it will have to pay more to the workers it would have had anyway, so the marginal cost of an additional worker to the firm is higher than that worker’s wage.

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Figure 7

We’re all familiar with the fact that when a firm has market power over what it sells, it would always like to sell more than it can at the current price. A firm that has monopsony power over labor is in the same situation with regard to hiring: it would normally be happy to get more workers if it could do so without paying higher wages. That is, complaints about labor and/or skill shortages are normal for many employers, just like complaints about not having enough sales.

But here’s the thing: during the years of high unemployment, firms faced both reduced demand – lower marginal revenue product – and increased supply of labor, from workers desperate for jobs. This “should” have allowed them to cut wages – but for the most part they couldn’t, because wage cuts have lots of adverse side effects.

So for a while the usual complaints about the supply and/or quality of workers were in abeyance. Given the wages firms were still offering, willing workers were abundant.

But now demand has recovered, unemployment is low, and normality has been restored. Once again, firms are complaining that they can’t find workers without raising wages – which is the normal state of affairs.

It’s true that the complaints seem even louder than in previous business cycle peaks. But I can offer a couple of reasons.

One is simply that it has been a long time since labor markets were tight. Most HR managers, I would guess, don’t remember what a full employment economy is like. They find the idea that there aren’t tons of highly qualified workers lined up for every job opening shocking – and, inevitably, blame the workers.

More speculatively, I’ve suggested that employers are especially unwilling to raise wages because they remember the Great Recession, and don’t want to lock in higher wage costs.

Either way, I’d argue that the combination of downward nominal wage rigidity and monopsony power helps explain both why wages didn’t fall during the period of high unemployment and why employers aren’t doing much to raise wages despite tight labor markets now.

4. Policy implications

The bottom line here is that I reluctantly find myself on the no slack side of this debate. I think the U.S. really is more or less at full employment.

But do I think the Fed is right to be raising rates, and that we should start being worried about fiscal deficits? Actually, no, for two reasons.

First, I might be wrong. And the costs of tightening when the economy still has room to grow are much bigger than those of waiting and discovering that we’ve overshot a bit.

Second, everything we’ve learned since a 2% inflation target became orthodoxy suggests that the target was too low. The effective lower bound on interest rates is a much bigger threat than we realized, and the problem of downward wage rigidity is a bigger deal too. So if inflation crept up from 2 to 3 or even 4, that would actually be a good thing.

So while I am not convinced that we have a lot of labor market slack, I actually favor policies that act as if we did. Hey, nobody except fools said economic policy was easy.